The single most powerful determinant of how positive or negative the outcomes of Say on Pay shareholder votes will be is the overall alignment of CEO pay to company performance. And yet, despite the importance of pay/performance alignment, there is no universally agreed-upon test to determine its existence or strength. There is general agreement that TSR is the best performance metric, but there is substantial disagreement over how best to measure CEO pay. Some analysts, like ISS does for its SOP vote recommendations, use a variant of compensation opportunity while others, like Pay Governance use realizable pay. By simulating the ISS RDA CEO pay for performance test, we analyze the efficacy of using pay opportunity in measuring pay and performance alignment in comparison to using realizable pay.
1. Many large companies may receive “high concern” or “medium concern” ratings for pay-for-performance alignment – and in more extreme cases, “against” recommendations for Say-on-Pay (SOP) votes from Institutional Shareholder Services (ISS) – despite the reality that, when properly measured, their pay programs exhibit true alignment.
2. There are many ways to measure CEO pay and its alignment with multi-year company total shareholder return (TSR). Based upon our research, we believe that realizable pay is the preferable metric for this comparison. Value delivered — not valued granted — should be aligned with performance. This is the distinction that boards, in designing pay programs, and executives, in receiving annual grants of pay opportunity, expect.
3. Studying CEO pay at large companies, we tested pay/performance alignment across all industries in two ways: (i) using realizable pay and (ii) using pay opportunity in a manner similar to the new ISS Relative Degree of Alignment (RDA) test. Using realizable pay, we found that more than 91% of large public companies have pay programs that are aligned with TSR.
4. Using both tests, approximately 86% of the companies examined exhibited the same results regarding alignment versus misalignment. However, our comparison of the two tests revealed:
a. False negatives. We found that more than 10% of the companies for which the ISS opportunity-based test found misalignment (high pay opportunity with low TSR) had realizable pay that was actually aligned with performance. Neither board members nor executives expect pay opportunity to be aligned with TSR.
b. False positives. We found a small number of companies, less than 4%, for which the ISS test found to have achieved alignment that actually had high realizable pay and low TSR. This is a very small group of companies with particular circumstances
5. We found that in both tests, the level of pay opportunity relative to market levels plays a role in pay/performance alignment results; companies shown to be of high concern were also the group of companies with the highest pay opportunity.
6. Further, the companies with false negatives had extremely low relative TSR, which resulted in low realizable pay. Yet, since the ISS test measures pay opportunity but not realizable pay, it incorrectly indicated pay/performance misalignment. Thus, the ISS test results are often found to be a mystery at best and a frustrating disappointment at worst for the boards of these companies.
7. Lastly, companies that showed poor alignment regarding realizable pay typically had a steep dip in stock price from 2008 to 2009, with only partial recovery by 2010. However, stock grants made in 2009 had a relatively high value of realizable pay (53% of three-year total compensation), which increased amounts for three-year total realizable pay even though overall alignment of pay to TSR for the three-year period was lacking.
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